What Gold Supply Crunch?

We have reported on changes in global gold demand, from booming
investment demand in Asia to European and US debt concerns that have
re-solidified gold's long tenure as the ultimate safe-haven asset for
turbulent times. In fact, with investment demand from private and
institutional buyers continuing to grow and central banks increasing
their gold reserves, total demand reached a record US$57.7 billion in
the third quarter of 2011. Quite astounding.

But what's happening on the supply side of the equation?

The
most important source of gold supply is mine production – which is
responsible for about two-thirds of the total – followed by recycled
gold. While recycled gold is the reason supply is inelastic, new
production has more predictive power since it can reflect shifts in
industry conditions and investor sentiment.

Starting with a bird's-eye view, take a look at global gold production since 1900.

(Click on image to enlarge)

The
1980 gold mania occurred when gold supply had the same structure as it
does today: two-thirds from production and one-third from recycled
product. As the chart shows, in the 1980s, production increased after the short-lived mania came to an end, while this time around,
production has already gone up (more on that below). Also, as the 1980s
wore on, production grew in spite of the price falling dramatically.

History
doesn't repeat exactly, but it often does rhyme, so comparing the
1970-1980 decade to the present can give us a useful context for
thinking about gold today. Reviewing the data available, here are some
key comparisons:

The previous major interim peak in mine
production was recorded in 1970, followed by a 10-year decline and
ultimately, the 1980 peak in gold's price. It's interesting to note that
the mania occurred when gold supply was flat.

This cycle, we have an interim peak in 2001, followed by a decline for
seven years, and then a reversal of the trend in the last three years.
On average, production decreased at 0.2% per year (2000-2010). But
looking at the decade average ignores the trend reversal in the last
three years: Gold production rose by 7.4% in 2009, 3.7% in 2010, and is
up 5% in the three quarters of 2011 compared to the same period in 2010.

This recent increase in production without a market mania beforehand
could be seen as an argument against there being a mania this time
around: There's no supply crunch. Supply could keep up with demand and
prevent the crunch from happening. We don't see this being likely for
several reasons, foremost among which is that we don't see the increases
in production being sustainable. Mines are by definition depleting
assets, and it gets harder every year to permit and place new mines into
production.
Global gold reserves in 1980
tallied 1.1 billion ounces (34,000 metric tonnes), and production at
that time was sufficient to meet demand at the time for about 20 years.
In 2010, reserves were 1.6 billion ounces (51,000 metric tonnes) and
were also sufficient to meet demand for an identical 20 years, but
production was twice as high. Much of this can be attributed to
improvements in mining technology that, coupled with higher prices,
allow larger, lower-grade deposits to be mined profitably. Again: no
supply crunch.

Not yet, anyway. In addition to the increasing regulatory burdens, the
discovery process has grown more arduous. There are new technologies
that have made some things much easier, but overall, most explorers have
to go farther and search harder every year.
Gold
production has outpaced the increase in the population. In fact, gold
production per capita now is even higher than in the 1970s. No crunch
evident from this perspective either.

1970-1980 Gold Production Per Capita

2000-2010 Gold ProductionPer Capita

At interim peak (1970): 0.40 grams

At interim peak (2001): 0.42 grams

During mania phase (1980-1981):0.28 grams

Current value (2010-2011): 0.37 grams

Source: USGS, World Bank

However,
gold is not a consumer good – it's not something people need to eat a
certain amount of every day, so the physical quantity of gold per person
in the world means less than it would for other commodities. Gold, we
have long argued, is a "fear barometer" in today's world. It's valued,
which means it has demand in inverse proportion to people's confidence
in other forms of money. So the fact that supply has kept up with
population growth does not imply that supply has – or "should have" –
kept up with demand… and we can see that it hasn't in the price of gold.
A major part of that is the return of investment demand, almost to
levels we saw in 1980, as you can see in the chart below.

(Click on image to enlarge)

Today,
as in 1980, mine production and scrap are the major components – almost
the only components – of supply. The disappearance of net disinvestment
from the supply side of things is one of the more bullish similarities
we see between now and 30 years ago.

(Click on image to enlarge)

One
major difference between the gold market today and in decades past is
the geography of mine production. South Africa accounted for two-thirds
of global gold production in 1970 and 55% in 1980. In 2010, not one
country was responsible for more than 14% of world mining supply (with
the leader being China, at 13%).

A similar shift has occurred with demand. In the 1980, it was mostly
Western countries soaking up the gold trade, probably because that's
where most of the wealth that wanted to avoid inflation was. By 2000,
when gold was held in the same esteem as certain other four-letter
words, North America and Europe had almost left the field. Today, it's
become a truly global trade again, as you can see in the chart below.

(Click on image to enlarge)

Such
decentralization has benefits: It creates flexibility and stability in
the gold market. The market psychology is more diverse, making it more
liquid and robust.

No Crunch Today – Crunch Tomorrow?

Your
Casey Research metals team believes the supply of gold is going to
tighten. Most companies have been forced to look in riskier
jurisdictions and remote locations with poor infrastructure.
Environmental and other regulations are multiplying and becoming more
costly every year, and even in places where they are not, labor strikes
and increases in taxes are taking their toll. Worldwide, mining becomes
more complicated and expensive every year… and in some cases, not even
worth trying. At the same time, big discoveries remain few and far
between – and even when a discovery is made, it often takes up to ten
years to reach production.

As they say, the low-hanging fruit has been picked: We do expect a supply crunch in the years ahead.

It's
tempting to try to make an argument based on future constraints in gold
supply and some of the interesting similarities between past and
present conditions in that supply – they seem to point to a gold mania
ahead. But it's the demand side that dominates the price of gold.
Whether a shortage of gold supply from production occurs or not, demand
for gold is more flexible than supply overall.

Gold is a monetary
metal. If confidence in paper money evaporates the way we think it will,
the flight to the safe haven of gold could swamp any conceivable glut
in supply. We've no crystal ball to tell us when it will start, but we
definitely see a mania coming.

And another question arises: Now that gold demand and supply are dispersed across the globe, where will the mania start? US? Europe? How about China, India, or Malaysia?
Things could really start cooking with no immediately evident cause in
the West at all.

Regardless of when or where the mania starts, our advice is to make sure your personal gold reserves are in place.